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U.S. Economic Outlook: Third Quarter 2018

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U.S. Economic Outlook: Third Quarter 2018

PR Newswire

BIRMINGHAM, Ala., Aug. 24, 2018 /PRNewswire/ -- In recent months, concerns surrounding the financial health of the business sector have been on the rise. In particular, market participants are worried that higher price pressures, faster monetary policy normalization, and a trade war, amid stretched valuations, could trigger a significant decline in risk appetite.

BBVA Compass corporate logo (PRNewsFoto/BBVA Compass)

This would lead to higher borrowing costs and tighter financial conditions. In this environment, financial pressures would increase significantly, particularly for businesses with lower credit ratings, high leverage, and in sectors struggling with profitability. A wave of corporate defaults and systemic financial stress will have a sizeable negative impact on investment and employment, and bring about an economic recession.

Massive increase in business leverage
To some extent, these concerns seem justified, particularly considering the massive increase in business leverage since the Great Recession and a greater share of lower credit quality debt. In 1Q18, nonfinancial corporate debt (securities and loans) reached a new high of $9.1 trillion, an increase of $2.9 trillion or 48 percent since 1Q10. As a result, in the last eight years, the ratio of debt to GDP has increased from 40 percent to an all-time high of 46 percent. In almost all recessions since the 1950s, this ratio has edged up significantly prior to the economic downturn. Thus, the sharp increase in business leverage could soon prove unsustainable if interest rates rise too fast, asset valuations decline, demand for high-yielding assets weakens, and lending supply from institutional investors – collateralized loan obligations, hedge funds, private equity firms, etc.- becomes constrained.

Excesses in credit markets
Evidence of excesses in credit markets is also concerning. In 2017, leveraged loans issuance reached a new record high; around 65 percent of new loans were rated B- or less, and 75 percent of new institutional loans were covenant-lite (lacking usual protection for lenders). Around half of total borrowings were used to fund M&A activity, leveraged buyouts, dividends, and share buybacks. In addition, the share of speculative-grade corporate issuers rated B- or lower stands at its highest level (25 percent) since the financial crisis.

Increase in leveraged loans
The large increase in leveraged loans and speculative bond issuance could become a source of risk if market conditions reverse. Although traditional metrics like price-to-earnings and price-to-book are below previous peaks, they remain elevated and are well above historical averages. Therefore, modest changes to the projected path of interest rates, equity risk premium or expected earnings could cause a major asset price correction. Already, default rates for high yield bonds and loans are trending up while yields for BBB- and BB-rated corporate bonds have increased around 70 and 100 basis points since year-end 2017, respectively. These developments resemble the decline in risk appetite for lower-rated borrowers that occurs during the later stages of the credit cycle. If that is the case, the adjustment could be more severe this time around given the higher reliance on leverage loans and increased influence of nonbank institutional investors.

Risks remain contained
Notwithstanding these trends, several factors show that the risks are still contained. Overall, monetary policy remains accommodative, and both borrowing costs and bond spreads are lower than historical averages. In fact, a considerable share of speculative-grade debt expected to mature in 2018 and 2019 has already been refinanced. Total net interest payments for nonfinancial corporate business are growing below their historical average and the ratio of debt-to-net worth is slightly below its historical trend. In addition, distress ratios remain contained across sectors excluding retail, restaurants and telecommunications, which are undergoing structural disruptions. Moreover, profit growth is expected to remain robust supported by ongoing GDP growth, while recent business tax cuts will ease cash flow pressures and boost profits for several more quarters. In sum, although it is still early to sound the alarm bells, downside risks from elevated business leverage are likely to continue increasing.

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 About BBVA Group
BBVA (NYSE:BBVA) is a customer-centric global financial services group founded in 1857. The Group has a strong leadership position in the Spanish market, is the largest financial institution in Mexico, it has leading franchises in South America and the Sunbelt Region of the United States; and it is also the leading shareholder in Garanti, Turkey's biggest bank for market capitalization. Its diversified business is focused on high-growth markets and it relies on technology as a key sustainable competitive advantage. Corporate responsibility is at the core of its business model. BBVA fosters financial education and inclusion, and supports scientific research and culture. It operates with the highest integrity, a long-term vision and applies the best practices. More information about BBVA Group can be found at bbva.com.

About BBVA Compass
BBVA Compass is a Sunbelt-based financial institution that operates 645 branches, including 332 in Texas, 89 in Alabama, 63 in Arizona, 61 in California, 45 in Florida, 37 in Colorado and 18 in New Mexico. BBVA Compass ranks among the top 25 largest U.S. commercial banks based on deposit market share and ranks among the largest banks in Alabama (2nd), Texas (4th) and Arizona (6th). BBVA Compass has been recognized as one of the leading small business lenders by the Small Business Administration (SBA) and ranked 6th nationally in the total number of SBA loans originated in fiscal year 2017. Additional information about BBVA Compass can be found at www.bbvacompass.com. For more BBVA Compass news, follow @BBVACompassNews on Twitter, visit newsroom.bbvacompass.com, or visit bbva.com.

 

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